Free Banking and Credit Creation: Implications for Business Cycle Theory

Volume 3, No. 3 (Fall 2000)

Free banking is a process where the market makes the ultimate judgment on where to draw the line between money as a present good and money as a future good. Bankers must make a judgment on the proportion of their deposits that represent saving and the proportion that are currently serving as present money for the holders of the deposits. Only funds held as savings may be safely “invested” or loaned. Consumers of banking services make judgments about the safety and soundness of the banking institutions with which they deal. Successful banks will provide the mix of services that meet the needs of their clients. The market test makes it qualitatively difficult to distinguish the Mises from the Selgin outcome. While Mises expected the discipline of the market to move banks closer to the 100-percent-reserve position, Selgin anticipates lower levels of reserves and hence more intermediation and lending. Just as Marshall’s short run blends into the long run, the practical aspects of Mises’s theory of money, credit, and banking blend into the theory of free banking provided by Selgin.